LSTA v. SEC on Appeal – Is the CLO Risk Retention Requirement at Risk?

Thursday, November 9th, 2017 at 7:54 pm, by Daniel Feder

In response to the financial crisis of 2008, Congress passed landmark financial legislation in 2010: the Dodd-Frank Wall Street Reform and Consumer Protection Act. In order to limit the systemic risk that deepened and extended the crisis’s impact, Dodd-Frank tasked a variety of financial regulators with promulgating rules on a wide variety of topics. As the regulators develop standards and subject financial entities to new obligations, the regulations have resulted in challenges to those rules which entities feel go too far.

One such recent challenge is making its way through the courts in the case Loan Syndications & Trading Association v. Securities and Exchange Commission.[1] The controversy centers on rules jointly implemented by several regulators to effectuate the Dodd-Frank requirement that “any securitizer… retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party.” The rule required that open-market collateralized loan obligation (“CLO”) managers retain an economic interest in five percent of the credit risk of the CLO.[2] The Loan Syndications & Trading Association (“LSTA”), a “trade association representing members participating in the syndicated corporate loan market,”[3] brought the suit centrally to challenge the interpretation that CLO managers fit under the statute’s definition of “securitizer.”[4] The district court analyzed the question under the Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc. two-step framework, and granted the government’s motion for summary judgment.[5] However, recent rumblings emerging from the oral argument conducted before the D.C. Circuit indicate the appellate court may be willing to vacate the rule, causing rippling consequences for the agencies’(particularly the U.S. Securities and Exchange Commission and the Board of Governors of the Federal Reserve System, the parties in this case) efforts to implement Dodd-Frank.

The District Court Ruling

While LSTA raised several challenges, the district court primarily focused on the concerns raised by the government’s interpretation that the term “securitizer” included CLO managers.[6] Congress defined “securitizer” as “(A) an issuer of an asset-backed security; or (B) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly… to the issuer.”[7] Open-market CLO managers select the loans included in the CLO collateral pool, generally in their sole discretion,[8] but operate only as an agent for investors; they do not originate the loans, and never have ownership or possession of the assets in question.[9] LSTA argued that CLO managers therefore did not sell or transfer assets, and that the government’s interpretation was foreclosed by the statutory definition.[10]

The Chevron two-step test requires that courts defer to an agency’s construction of the statute, provided “Congress did not unambiguously foreclose the agencies’ construction; and… the agencies’ construction is reasonable.”[11] The district court determined that Congress broadly delegated whether a type of entity is a “securitizer” by (1) picking up sales or transfers made “directly or indirectly,” (2) allowing the two prongs of the definition to operate disjunctively, and (3) explicitly exempting certain institutions (not including CLO managers) from the requirements.[12] Further, the court rejected LSTA’s claim “that Congress was principally concerned with abuses in the “originate-to-distribute” model,” which would not have required regulating open market CLOs, as they are not involved in originating the assets.[13] Instead, the court agreed with the agencies that the intent of the law was to “broadly delegate the task of regulation in this complex market to the expert agencies.”[14] The statute’s broad statements left significant room for the agencies to make their own determinations, passing Chevron’s first step.

The district court also found the agencies’ construction reasonable under the second step of the Chevron analysis.[15] As CLO managers select the commercial loans comprising the CLO, subjecting them to the risk retention requirement is the strategy most likely to incentivize monitoring the assets’ quality.[16] Placing the burden on the investors would ask entities with no control over the asset’s risk profile to internalize the credit risk; since those entities cannot change the CLO’s makeup, this approach would not reduce systemic risk.[17] Further, a CLO manager is the entity which “organizes and initiates” the transaction, and so are the only entity which could be described by the definition of “securitizer;” if the manager’s activities are not an indirect transfer, there may not be any institution subject to the risk-retention rule.[18]

As the agencies’ actions met both steps of the Chevron test, the district court granted the defendants’ motion for summary judgment. However, LSTA appealed the decision to the D.C. Circuit, and, following oral argument, there is considerable uncertainty about whether the district court’s decision will stand.

Oral Argument on Appeal

Despite the Chevron test’s deference to agency construction, the panel judges appeared sympathetic to LSTA’s claims during the oral argument conducted on October 10. During LSTA’s arguments, the judges mainly chimed in to prompt the petitioners’ lines of argument, rather than undermining or probing the conclusions. For instance, the panel pointed out that, contrary to the claim that only the CLO managers could be included in the definition of “securitizer,” the issuing entity could be subjected to the risk retention requirement under prong (A). Stretching prong (B) to include the CLO manager was unnecessary. Further, on rebuttal, one judge prompted a discussion of Congress’s intent; when the LSTA discussed the legislative history’s focus on mitigating risk generated by the “originate-to-distribute” model, the judge appeared to agree.

By contrast, the judges expressed significant concern with the government’s analysis. The panel quickly stopped the argument to note that if CLO managers were treated differently from entities involved in other asset classes – none of which, the government conceded, have requested review – the agencies would only have to promulgate two rules. The panel also raised concerns that the government’s construction of the statute rendered prong (A) of the definition of “securitizer” purposeless, and challenged the government’s claims that “issuer” meant the special purpose vehicle under prong (B), but carried no meaning for open market CLOs under prong (A). Additionally, during a back-and-forth on whether the manager’s activity fit any definition of “transfer,” a judge pointed out that the regulatory interpretation must be founded on the statutory language, regardless of whether that would create a loophole. The judge characterized the government’s construction of the statute as credulously accepting that the purchaser’s agent is somehow transferring the assets to the purchaser.

While it is difficult to predict a cases’ resolution from discussions at oral arguments, the questions posed to each side indicated the court may overturn the grant of summary judgment. The judges’ questions for LSTA implied a belief that the agencies’ construction was unreasonable in light of options more aligned with congressional intent. Their comments during the government’s argument further indicated an inclination that Congress did unambiguously foreclose the agencies’ construction by using the word “transfer.” If these hints prove accurate, the D.C. Circuit may find the rule fails the Chevron test and request the agencies return to the drawing board to implement the statutory mandate.

[1] Loan Syndications & Trading Association v. Securities and Exchange Commission, 223 F.Supp.3d 37 (2016).

[2] Id. at 45–46.

[3] Id. at 43.

[4] Id. at 44–45.

[5] Loan Syndications, 223 F.Supp.3d at 43.

[6] Id. at 44–45.

[7] 15 U.S.C. § 78o-11(a)(3).

[8] Loan Syndications, 223 F.Supp.3d at 55.

[9] Id. at 53.

[10] Id.

[11] Id. at 49.

[12] Id. at 51-52.

[13] Id. at 52.

[14] Id.

[15] Id. at 58.

[16] Id. at 55.

[17] Id.

[18] Id.